Believe it or not, you can have a million dollars socked away in your retirement accounts and it won’t affect your child’s eligibility for college aid. That's one reason why parents should save as much as they can in their own retirement accounts while their children are young, even though college bills come earlier than retirement.

Of course saving for both your own retirement and your kids’ education isn’t as simple as loading up your retirement accounts. If you do put a pile of money in your retirement accounts early on, you’ll still need cash to help pay for college, even if you do get some aid. So you need to save both inside and outside of retirement plans.

What’s the best way to do both? To start with, study the rules governing college aid. These rules have long been criticized for being too illogical, too plentiful and too technical. But for those who understand the way college aid eligibility is calculated, they can also be downright beneficial.

There are two types of college aid: Need-based, which is based on family finances, and merit aid, which is based on the child’s academic merit or some talent like drama, athletics or art. Mostly though, merit aid is academic in nature and if you have the grade, you get the aid. Need-based financial aid, as the name implies, is based on the student’s demonstrated “need” for aid.

“Need” is demonstrated through a formula: The Cost of Attendance at a school, minus your Expected Family Contribution (EFC) equals your Need. The higher the cost of the college and the lower your family’s expected contribution from assets and income, the greater the student’s potential aid eligibility. The question is, how should you save for college and retirement and keep your EFC low enough to get some aid to help pay for the rapidly rising cost of college? In the calculation of EFC, the formula rewards saving in certain types of accounts versus others.

Expected Family Contribution (EFC) is calculated based on the income and assets of the parents and student using three methods: Federal, Institutional and Consensus. Most colleges require students to complete only the Free Application For Federal Student Aid (FAFSA), which helps determine whether your family qualifies for federal Pell grants or subsidized student loans. But more than 300 colleges also require the CSS Profile aid application to be completed to receive their institutional aid (meaning, discounts on their tuition).

The FAFSA corresponds to the Federal Methodology (FM), and the CSS Profile to the Institutional Methodology (IM). The 568 (College) President’s Group has 26 member colleges (mostly elite institutions) that also require the CSS Profile, but their Consensus Methodology (CM) varies slightly from the IM.

All three formulas weigh current income much more heavily than accumulated assets. A standard income protection (meaning living) allowance, as well as federal, state and payroll taxes are subtracted from the parents’ adjusted gross income (AGI). After all of those allowances are subtracted, you’re left with net reportable income and the colleges expect you to use up to 47% of that amount for college. But here’s something that might surprise you, if a parent is currently making contributions (elective deferrals) to a 401k or similar plan, the contributions gets added back to the parents’ AGI before the calculation of net reportable income. In other words, the formula makes no allowance for contributions to a retirement plan while your kids are in school.

What about assets? Here it’s a very different story. Those assets that are already in qualified retirement plans and IRAs do not get counted as assets of the parents at all. For example, in 2012, after choosing to contribute $12,000 from their salaries into their employers’ 401k plans; Bill and Jill have an adjusted gross income of $140,000 ($152,000 combined salaries - $12,000 combined 401k contributions = $140,000 adjusted gross income; line 37 on form 1040 or line 21 on form 1040A). The value of their combined 401k accounts is $450,000. So in early 2013, when they complete the Free Application For Federal Student Aid (FAFSA), they will report their 2012 adjusted gross income of $140,000 on line 83, and their 401k contributions for 2012 on line 92.

When the data from their son’s FAFSA gets run through the Federal Methodology calculation for determining his expected family contribution, their $12,000 in 401k contributions will get added back to their AGI of $140,000, and for financial aid purposes, their income will be $152,000, their AGI plus their 401k contributions. The aid formula presumes that they could have used that money they’re setting aside for retirement to pay for college instead. But the good news is that they will not have to report the $450,000 value of their 401k accounts as an asset on line 89. So the formula counts the current-year contributions to retirement accounts, for which parents’ receive a tax deduction, but not the typically much higher asset values already in the plan—a good trade-off for those who saved early.

On the CSS Profile, retirement plan asset values do need to be reported along with current-year plan contributions. But again, the retirement asset values do not get included in the Institutional or Consensus Methodology’s calculation of EFC. So why then does the CSS Profile ask for retirement plan values? In a case where a financial aid officer has to make a judgment call (professional judgment) about adjusting a student’s EFC due to unusual circumstances like loss of a job or excessive medical bills, he or she may use the information about retirement accounts to assess the family’s overall financial well-being.

On the other hand, assets that aren’t in retirement accounts ---your balances in checking, savings, CDs, money market, investment real estate, stocks, bonds, mutual funds, ETFs, commodities, etc.---do get included in the EFC formulas. Your total reportable assets will vary depending upon the EFC methodology, and from that reportable asset value a modest savings allowance of about $40,00 to $50,000 is subtracted to arrive at an available asset value. A parent is then expected to use up to 5.64% (Federal) and 5% (Institutional and Consensus), of those available assets each year on college. The bottom line: $200,000 saved in retirement accounts will raise the student’s EFC $0 per year, whereas $200,000 invested in the parent’s brokerage account will raise the student’s EFC by $11,280 per year, or a little more than $45,000 over four years. That's equivalent to the national average cost of two years of college at a state university.

Small businesses, home equity and non-qualified annuities are not counted in the FM, but they are in the IM and CM, although, under the CM home equity is capped at 1.2 times the parent’s adjusted gross income. Assets that are owned by the student are counted at a rate of 20% (FM), 25% (IM) and 5% (CM), but under the FM, 529 college savings accounts and education savings accounts are counted as parent’s assets (5.64%) even though they are owned by the student. Life insurance cash values and personal assets like cars do not count under any of the formulas.

Bottom line: the various EFC formulas and their corresponding aid forms require different information about the family and their finances, and each calculates the child’s EFC differently, giving different allowances against parent and student income and assessing the assets differently. Thus, knowing which colleges use which formula, and how your family’s finances match up with the respective formulas is a good thing. For example, conventional wisdom says that saving in a child’s name is bad for aid eligibility---and it can be. But it can make sense (and save a little bit of tax) if you have such a high income that you won’t qualify for need-based aid regardless of whose names you save in. You can identify your estimated EFC based on income alone using my recent 2013 Simplified Guide To Expected Family Contribution (EFC) And College Aid.

Assuming you may qualify for aid, here’s a run-down of the different buckets and strategies you can and should use to save for both retirement and college.

Qualified Plans

First, save in qualified retirement plans such as 401(k)s, especially to take advantage of company matching contributions. Matching contributions don’t count against aid eligibility either. What’s more, if you are the employer/business owner, contributions that the company makes to your account are not added-back to your income. Only elective employee deferrals of salary are added back, as are deductible IRA contributions.

Roth IRA

Second, save in a Roth IRA. Like a regular IRA, it does not count as an asset for aid purposes. Since contributions to a Roth IRA are made after-tax (no deduction), they are already part of your AGI and don’t get added back in. The Roth will also give you some tax diversification at retirement, and a second source of income. If need be, you can even pull your contributions out of the Roth to help pay college expenses without tax or penalty. For more on Roth IRAs see my post Time Roth Conversions For More College Aid And Less Tax.